With structural reforms of labour markets currently being considered in several countries, including in southern Europe, assessing their impact is vital. This column investigates the effects of employment protection legislation on a variety of production factors. Structural reforms that increase labour flexibility – that is, which weaken employment protection legislation – could have a favourable impact on firms’ R&D investment and their hiring of low-skilled workers.

Numerous papers have been devoted to exploring the impact of labour market regulations on production factor demand. To measure labour market regulations, many of them have used the OECD’s Employment Protection Legislation (EPL) indicators, which assess the procedures and costs involved in dismissing individuals or groups of workers and the procedures involved in hiring workers on fixed-term or temporary work agency contracts. Their results are very important to characterise and evaluate the possible impact of labour market structural reforms, with such reforms currently being considered in several countries including in southern Europe. Most of these papers have focused on the impact of EPL on innovation and productivity,1 usually finding a detrimental impact of strengthening EPL on patents, total factor productivity (TFP), or growth.

Fewer papers have been devoted to exploring the impact of EPL on the combination of production factors, although this aspect is essential for anticipating the many effects of labour market reforms, such as the impact on firm investment. Some of these papers investigate the impact of EPL on total capital intensity (i.e. the total capital-to-labour ratio) and find a positive impact of strengthening EPL (Autor et al. 2007, Calgagnini et al. 2014, Cingano et al. 2010, 2014, Janiak and Wasmer 2014).2 However, other papers that investigate the impact on capital composition or ‘quality’ in terms of ICT intensity find a negative impact of strengthening EPL (e.g. Aghion et al. 2009, Cette and Lopez 2012, Guerrieri et al. 2011).3 A number of these papers also show complementarities between capital accumulation and skills, but none investigates thoroughly the different effects of EPL on a variety of production factors, as we do here.

A new approach4

We study the effects of labour market regulations, measured by the OECD indicator of EPL, on the capital-labour ratio for four components of total capital stock (R&D, ICT, non-ICT equipment, and construction) and two labour components (low and high skills). An originality of our analysis is that it is built on one single body of data – a country-industry panel dataset of 14 OECD countries, 18 manufacturing and market service industries, over the 20 years from 1988 to 2007. Another original contribution is the use of a difference-in-difference methodology, testing whether the impact of EPL depends on the intensity of the use of labour. The estimated specification of the impact of EPL on the production-factor combination is derived from firm maximisation, assuming perfect markets for products and capital but not for labour. It also assumes a symmetric approach for each factor, with elasticity of substitution that may differ between factors, which is consistent with various degrees of complementarity/substitutability between factors, and notably a possible complementarity between high-skilled workers and capital.

The main results are that: (i) non-ICT physical capital intensity increases overall with EPL; (ii) ICT capital intensity is not significantly impacted by EPL; (iii) R&D capital intensity decreases with EPL; and (iv) the share of high-skilled (low-skilled) workers in total employment increases (decreases) with EPL. These results support the fact that an increase in EPL is seen by firms as a rise in labour costs, with a capital-to-labour substitution impact in favour of non-sophisticated technologies, and is particularly detrimental to unskilled workers.

Impact of labour market reforms

To illustrate the meaning of our results, we compute for all countries in our dataset the impact of the adoption of the US 2013 EPL level (the US being the country with the lightest level of regulation according to the OECD EPL indicator, and 2013 being the last year the EPL indicator was available). The adoption of this US EPL level would require large-scale labour market structural reforms in some countries – such as France and Italy – necessitating very ambitious reform programmes. Therefore, this simulation cannot be considered politically and socially realistic over a a short period of time. But considering the favourable impact of labour market reforms on productivity and growth (e.g. Cette 2016a), these reforms could be considered as a long-term political goal.

The main results of this simulation are the following:

The impact is always largest in France, followed by Italy, Spain and the Czech Republic. These four countries suffering from the highest EPL level. At the other end of the scale, the impact is always smallest in the UK which appears to be the least regulated country after the US.

The capital-labour ratio would decrease by between 1.4% and 8.1% for non-ICT equipment and by between 0.5% and 3.0% for construction (Figure 1). Conversely, it would increase by between 0.7% and 4.1% for ICTs and by between 9.5% and 54.1% for R&D. This large R&D impact must be related to the fact that R&D only accounts on average for 9.7% of the capital stock in industries where R&D investment is not negligible, and 7.1% in all industries.

The proportion of the share of low-skilled employment increases by between 3.1% and 17.8%, and the proportion of the share of high-skilled employment decreases by between 3.8% and 21.9% (Figure 2).

Figure 2 Long-term impact of adopting the US EPL on employment share by skill level

It appears that EPL is particularly detrimental to low-skilled employment, which is an interesting paradox as one of the main goals of EPL is to protect low-skilled workers. These regulations seem to frighten employers, who see them as a labour-cost increase with consequently a negative impact on low-skilled employment. From our knowledge of the literature, this result is original. It supports the idea put forward by Janiak and Wasmer (2014) that higher labour regulations increase the capital-to-labour ratio and, due to the complementarity between capital and high-skilled workers, the share of the latter in total employment. But our results provide more details about this channel: the added capital is not the most sophisticated one. From higher EPL, the ICT capital-to-labour ratio does not significantly change, and the R&D capital to labour ratio even decreases significantly.

Authors note: The views expressed in this column are those of the authors and do not necessarily reflect those of the institutions to which they belong.

Endnotes

[2] Autor et al. (2007) show that the adoption of wrongful discharge protection by state courts in the US from 1970 to 1999 increased the capital-to-labour ratio, and Cingano et al. (2014) show that the implementation in Italy in 1990 of a reform that introduced unjust dismissal costs for firms below 15 employees had increased in these firms the capital-to-labour ratio. But using a panel of European firms, Cingano et al. (2010) and Calcagnini et al. (2014) fing a negative impact of EPL on the capital-to-labour ratio and on investment dynamics respectively. These results may be reconciled by idea of Janiak and Wasmer (2014) of an inverted U-shape relationship between the employment protection legislation and the capital-to-labour ratio: at a low (high) EPL level, a positive (negative) correlation appears between EPL and capital intensity.

[3] To our knowledge, there are no studies focusing on the impact of labour market regulations on R&D spending, but some previous papers have dealt with the similar topic of the impact of labour market regulations on patenting behavior. Griffith and Macartney (2014) give a survey of this literature and show an ambiguous relationship between EPL and innovation.